CV Sciences: Deceivingly Overvalued

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About: CV Sciences, Inc. (CVSI)
by: Singular Research
Summary

CV Sciences has growing revenues but free cash flow is lagging.

Excess inventory levels are expected to sustain revenue growth through 2019 without the need for any outside raising of capital.

A current buy-in position cannot be justified.

Background on CV Sciences (OTCQB:CVSI)

CV Sciences, Inc. (OTCQB:CVSI) is a life science company that operates two business segments - specialty pharmaceutical and consumer products. The consumer segment markets and manufactures hemp-based CBD under the name PlusCBD and is included in several sectors such as nutraceutical, beauty care, and specialty foods. Their pharmaceutical segment develops drug candidates using CBD as the primary active ingredient. The company seeks to focus on hemp-based products and bring back the production of it for all uses from ingestion products to hemp textiles. CVSI's primary strategy of funding growth is through revenue, however, raising additional capital has been required through equity and debt issuance.

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Performance Overview – Q1:19

  • Organic Expansion Drives Revenue. Revenue for Q1:19 came in at $14.9 million, an 85% increase from $8.1 during the prior year’s first quarter. The company’s diversified operating portfolio extends into all sales channels such as drug, food, wholesale, and direct-to-consumer channels. CVSI grew their geographic reach by adding an additional 1070 stores since the end of 2018. There are currently 3,308 stores nationwide. Adjusted EBITDA for Q1:19 was 11.3% of net revenue versus 22.6% in Q1:18.
  • Restructuring Management Increased Losses. The company’s founder/former CEO and president recently retired, increasing stock-based compensation and payroll expense associated with his absence. Operating loss for Q1:19 was $9.4 million vs. operating income of $0.7 million in Q1:18.

Sources: CVSI's Q1:19 earnings call

2019 Outlook

Current Assets Driving Sustainability In 2019

CV Science’s balance sheet is healthy and has seen consistent growth over the past year. Cash in the bank rose almost $1 million, an 111.4% increase over the past year. Along with an increase in cash, inventories have seen virtually identical growth, 116% over the past year. Management has indicated that they expect their excess current assets to sustain operations and expenses through 2019.

Lagging Free Cash Flow

When analyzing the company's free cash flow, the calculation used is standard and validated by management. The CFI calculation is the company's capital expenditures, which for CVSI is specifically their "purchase of equipment" and "tenant improvements to leasehold real estate."

Cash Flow from Operations - Cash Flow from Relevant Investing Activities.

Q1:19 saw a 59% decrease in the company's free cash flow. The lower FCF has been a reflection of higher working capital. Inventory additions in Q4, for example, and higher accounts receivables in Q1. In the case of Q1, it also related to severance with the founder retiring which led to lower earnings YoY.

Q1:19 saw a 94% decrease in investing activity outflows. It seems concerning at first, but the company also is positioned with a growing cash account and inventory will promote self sufficiency in 2019.

Management specified that as revenue continues to build and earnings increase, investors should expect higher FCF with the occasional exception of inventory building ahead of new orders. Though there are plans to expand capacity, management hasn't disclosed capex expectations for future expansion but indicates that operating cash flows will remain volatile from period to period because inventory purchases and customer accounts receivables fluctuate significantly.

Timing of these activities can be misleading to analysts in the short term as it creates fluctuations in the overall FCF. This volatility makes it difficult to make YoY FCF estimates for the company and judging when these changes will occur.

It’s historically not a good sign to see a complete lack of correlation between free cash flow and revenue, though it’s not uncommon to see this with rapidly-expanding companies. The vigorous reinvestment of capital is largely to blame and shouldn’t be looked at as a major concern in CVSI’s case. It’s too early to make a definitive judgment of this.

Valuation

We value CV Sciences with a 50/50 blended approach using a discounted cash flow and a price to sales method based on total addressable market vs. company market share. The model accounts for the company's financial performance while also acknowledging the high growth in the cannabis industry and favorable macro-economic conditions.

Discount Rate

The company’s cost of equity will act as the discount rate for both the DCF and P/S model. Total value of the firm is $48.39 million. The risk-free rate and market rate are 3% and 15%, respectively, leading to a cost of equity of 19.3%. Interest paid on debt is $6,000 and total debt is $17,514,000. A 20% tax rate is applied and leaves a pre and post-tax cost of debt which is virtually 0%. Because there's no debt risk, the 19.30% cost of equity will be used as the discount factor.

Total Assets $48.39 million
Equity Weight 63.8%
Debt Weight 36.2%
Beta 1.36
MRP 12%
Cost of Equity 19.3%
Cost of Debt 0%
Cost of Equity Discount Factor 19.3%

Multiple

CV Sciences will be valued using a 14.98x P/S multiple, rounded to 15x, derived from industry averages based on companies with similar operating portfolios and financial similarity. A P/S multiple is chosen over a standard P/E or EV/EBITDA multiple because the cannabis industry is largely unprofitable.

Discounted Cash Flow

The DCF model estimates free cash flow over the next four years with growth rates of -12.5%, 15%, 14%, and 10%, respectively. Applying the 19.3% discount factor and a perpetual growth of 7% leaves a PV-FCF of $5.80 million and a PV-terminal value of $8.88 million. The DCF model leaves the company valued at $14.68 million. Note that DCF cannot be used to value CV Sciences as a standalone for several reasons:

  • Limited operating history makes it difficult to estimate the growth of free cash flow for the company.
  • Due to the infancy of the cannabis industry and the company, cash outflows for investing activities will of course be higher than normal, unfairly devaluing the them in DCF.
  • Cash flows from operations will remain volatile because funding of inventory purchases and changes in accounts receivable can fluctuate significantly over short periods of time: i.e. quarter to quarter and day to day. Timing is key.
  • High overall industry growth requires external bullish assumptions that they'll snag a portion of market share in a best-case scenario.

The fair company value of $14.68 million divided by the total shares outstanding of 98.66 million leaves an intrinsic value of a mere $0.17 compared to a market value of $3.98.

Total Addressable Market Top Down

The estimated American cannabis industry is expected to reach $12B in sales by the end of 2019, $8.5B being recreational. Finding CVSI's share in all of this will be taken by assigning their consumer and pharmaceutical segments with different weights.

CV Sciences' consumer segment makes up 100% of their revenue, therefore weighted 100%. $14.9 million the past quarter was reported for this revenue stream.

When looking at assumptions for domestic market growth, only the consumer (recreational) portion will be used in my TAM model.

Assigning a value to the U.S.'s global market share usually starts by looking at our neighbors to the north and how they are handling the cannabis TAM bubble race. It's safe to assume that if the U.S. initiated a blanket legalization like Canada, the size of the U.S. market would smother theirs. Just look at the populations.

The population of Canada is approximately 37 million. California's is 40 million and the U.S.'s population is 328 million. If the U.S. and Canada were on equal legal grounds, California's market alone could exceed Canada's. Canada's estimated to have roughly 25% of the global market. It's conservative to assume that the U.S. can have 30%.

The U.S. recreational market size is projected to be $22B by the end of 2023. CVSI has seen consistent revenue growth, 5% QoQ for the last two quarters. Assuming this trend can continue, total revenue for 2019 will be $64.27 million by the end of 2019. Recreational sales in the U.S. is estimated to reach $8.5B. Therefore, CV Sciences has a current market share of about 0.008% domestically.

Because the company has made significant investments into their pharmaceutical segment, I'm giving them the benefit of the doubt and raising their market share to 1.5% by the end of 2023. This assumes that medical sales will start coming in within the next few quarters and that their diligent reinvestment of capital pays off.

Estimated American Cannabis Marketshare (of global) 30%
Projected American Cannabis Market Size (Recreational) - End 2023 $22B
CV Science's Estimated Domestic Market Share $1.5%

Net margin for the company is inputted as 10%, being hopeful that they can reach their 2018 profitability again. This combined with the 1.5% future market share gives them access to $33 million in net income by the end of 2023. Discounting this back four years to present with the 19.3% cost of equity leaves a present value of $20.72 million.

Total shares outstanding for the company is 98.66 million. Their projected sales per share of $0.17 combined with a 15x P/S multiple leaves a projected upside valuation of $2.48 in a best-case scenario.

Total Shares Outstanding 98,660,000
Projected Sales per Share $0.17
P/S Multiple 15x
Projected Upside Valuation $2.48

Weighting my DCF and TAM valuations equally, the blended valuation for CV Sciences is $1.32 per share.

Sources: Marijuana Business Daily, CV Science's Filings

Conclusion

CV Sciences is consistently growing revenues and is part of a rapidly developing industry. Macroeconomic conditions are playing in their favor, but despite this, the diminishing free cash flow could become a concern and will be watched closely when Q2 earnings are released to ensure that these are temporary fluctuations in their working capital.

Though the company is qualitatively attractive, the fundamentals highlight too much risk to buy in at the current price. At this time, we cannot justify a BUY rating for CV Sciences and assign a $1.32 per share fair value.

Disclosure: I am/we are short CVSI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.